The Independent Investor: Will the Municipal Bond Massacre Continue?

Bill Schmick02:59PM / Thursday December 30, 2010

There was a time when municipal bonds were a staid but safe investment. Tax conscious investors, widows and orphans would plow money into these debt issues of towns, cities and state municipalities fully expecting price stability and a predicable stream of interest payments. No more.

What makes municipal bonds appealing to many investors is that interest income received by holders of municipal bonds is often exempt from federal income tax and from the income tax of the state in which they are issued. But ever since the financial crisis and the recession that had accompanied it, state and local governments have had a hard time of it and their bonds have reflected that trading in a wide range similar to stocks and other riskier investments. Vast sums have been made and more recently lost in Muni bonds as investors bet on which states and towns would go bust and which would survive. The betting continues unabated.

Over the last two months, the entire $2.8 trillion market has seen a sizable decline in value. In just one day last month, for example, these bonds were hit by more than $3 billion in redemptions. By the end of that week, bond sales totaled $15.4 billion. The average municipal bond fund suffered a 3.7 percent loss for the month. Losses overall are approaching 6 percent for the year which is a modern-day record.

Underneath those headline figures is a market in which investors are feverishly sorting out those state and local governments with strong fundamentals and even stronger prospects and those that don't.

Forty-six states experienced budget shortfalls this year and 39 of them have projected gaps next year totaling $112 billion to $140 billion. Tax revenues this year dropped 3.1 percent, although that's an improvement over 2009's decline of 8.4 percent. However, most states expect property taxes to begin to decline next year. These taxes tend to lag real estate prices by about three years since assessments trail prices. Towns and municipalities rely on these taxes for at least 25 percent of their revenues and they look to the states for at least another third of their budget in state aid.

States have no money to lend, however, because their own taxes continue to decline due to the large number of unemployed, slow economic growth and the inability to raise taxes while residents are struggling to make ends meet. In 2011, states will also have to begin paying back to the federal government the $40.9 billion they borrowed interest-free through the stimulus plan.

In a similar fashion to the debt problems within some countries in Europe (Greece, Ireland, Portugal, Spain and Italy), here in the United States we too have our weaker states with Illinois and Nevada most often rated the states most likely to experience further economic turbulence. As in Europe, those weak sisters must pay substantially more in interest to attract investors to their bonds while states that have a better financial footing benefit by paying less.

In addition to the shaky finances and unknown risk that confronts this market in 2011 we also face the prospect of interest rate risk — the threat of higher interest rates in the government markets (see my column "Why Are Interest Rates Rising?").

Long-dated municipal bond prices and interest rates track long-term Treasury bond. Unfortunately, U.S. Treasury interest rates on the long end have spiked over the last two months and are predicted to move even higher in the New Year. For investors of both U.S. Treasury and municipal bonds that will mean further losses as bond prices decline.

If you must own municipal bonds, then switching from bond investments in weaker states and localities into bonds issued by stronger municipalities seems to me is common-sense tactic to employ right now. Secondly, stick with revenue bonds as opposed to general obligation bonds.

Revenue bonds repay investors from a specific source such as a highway toll rather than from a tax. General Obligation bonds, on the other hand, are secured by a state or local government's pledge to use whatever resources necessary (such as new taxes) to repay the bonds.

At the end of the day, Muni bond bulls argue correctly that if push came to shove the federal government would bail out any state that was on the verge of bankruptcy. In turn, any state would rush to the aid of a municipality within their domain that was on the verge of failure. I don't dispute that. And if it came to pass that something like that were to happen, it might be a buying opportunity to really aggressive traders but not for widows and orphans. For those who depend on these revenue streams to pay the bills, a far better approach is to simply sell the riskier securities and buy those that offer greater security.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

iBerkshires.com welcomes critical, respectful dialogue. Name-calling, personal attacks, libel, slander or foul language is not allowed. All comments are reviewed before posting and will be deleted or edited as necessary.

I find it very positive that more people are talking about muni's. However, I would like to point out a few things. You mention tax revenue has dropped 3.1% this year. State tax revenue (typically sales & income taxes) has been rising for three consecutive quarters; 2.5%, 1.0%, and 3.9% in Q3. Now it's true that assessed values have been declining but property tax revenue (typically 40-50% of local revs) are a very stable source of income. See charts below. Just think about your own house. Have your real estate taxes gone down along with you assessed value? Mine sure haven't. Also property taxes are first lien so if you foreclose the bank will pay your taxes because they're typically 2-3% of the total value of the house. So your assessed value can go down all day but the School District, County, town, & whomever else that has taxing authority will just raise their mill rate.

I don't think it's appropriate to mention states and local governments in the same breath as the PIIGS. They have a serious debt problem when the states just have a cash flow problem. When you add up the debt, pension, and OPEB's for NJ and IL (two of the most indebted states) your only looking at 28% & 18.6%, respectively, of Gross state product. Which is very very high compared to other states. But those numbers for Greece & Portugal are like 125% - 150%.

Three of the most indebted states New York, Illinois, and California would have to endure revenue declines of 96%, 85%, and 45% in order to endanger the states ability to pay debt service and senior payments. Average state revenue decline during the Great Depression was 18.2%

I'm not trying to contend things aren't tough for governemnts right now. They will be some tough choices to be made espceailly with the majority of federal stimulas dollars expiring in 2011. Which has propped up states budgets for the last two years.

What I am trying to contend is that muni's are the one of the safeist assest ( from a credit prespective) you can invest in. States and municipalities are required to balance their budgets each fiscal year. Most governments have the broad authority to raise taxes and fees. They also have the ability to cut services. Services that are not legally required of them to provide. One main expense of municipal budgets is payroll, which make them logistically easy to trim. It just takes political will power

I agree that revenue bonds are the place to be over lower rated General Obligation bonds right now. Feel free to shoot me an e-mail about muni's anytime. Have a happy new year.

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